Limited Company vs Sole Trader Tax

Starting a business is an adventure that is exciting, and full of self-discovery. That being said, one question that we get often here at Real Business is which business structure of these two is more tax efficient. The answer to the question isn’t an easy one, as both structures offer many benefits and unique drawbacks in terms of tax and more.

This guide will attempt to detail the tax implications of each structure as cohesively as possible, going over national insurance contributions, liability issues and how high you can save on taxes.

What is a Sole Trader?

The absolute simplest form of a sole trader is a business owner doing business as themselves, meaning there’s no legal separation between the owner and their business. This means that if a business goes into debt, the business owner will be liable for the debt. This is the main aspect that changes how a sole trader is affected by taxes.

Pros of a sole trader:

• Easy setup – Until you make over £1000 annually, you needn’t even register your business with Companies House. You can begin trading immediately.
• Less admin – Compared to a limited company, there are a lot fewer reporting requirements as a sole trader.
• Keep all the profits – All the profits after tax belong to the sole trader.

Cons of a sole trader:

• Unlimited liability – As we mentioned before, your assets are entirely on the line. If your business fails, and you incur debts, you will be liable to pay for the financial loss.
• Less tax efficient – At high-income levels, tax burdens can be even greater than they would be for a limited company.
• Credibility – Limited companies are more established than businesses, with plenty of information about the company being on public record. This increased level of scrutiny, if passed, can result in more people trusting a business over a limited company.

What taxes do sole traders pay?

• Income Tax – You must pay income tax on all of your business profits, just like you would on any other income. The amount you pay depends on your total income and the current tax rate.
• National insurance (NI) – If you are a sole trader, you are self-employed. This means you’ll pay class 2 and class 4 national insurance contributions, which count towards your state pension and other benefits.

What is a limited company?

A limited company is a separate legal entity from its owners, which would be made up of shareholders who have invested in said company. This means that if there are debts or other financial issues that affect the limited company, it is not the responsibility of the business owner(s) to repay – but rather the company and its business bank account.

Pros:

• Limited Liability – As described above, limited liability protection provides the owners and shareholders of the limited company with a sense of security.
• Potential Tax Efficiency – The efficiency of the tax rates that a limited company is entitled to can be highly beneficial when you reach a high earning bracket.
• Enhanced Credibility – A limited company is seen as established and professional due to the transparency that being on public record gives.

Cons

• More complex setup – Setting up a limited company requires a lot of paperwork, the instalment of a company director and a lot of ongoing administration.
• Ongoing compliance – Annual accounts, confirmation statements, corporation tax returns – there are a lot of checks and balances that must be made and adhered to internally.

What taxes does a limited company pay?

• Corporation tax – This is a tax paid on the company’s profits and it can be very advantageous.
• Income tax – Shareholders pay tax on salary and dividend payments they receive from the company.
• National insurance contributions – The company, as an employer, and employees/directors pay NI contributions on their salaries.

Income Tax – Sole Trader vs Limited Company

Sole traders and limited companies both approach income tax in different ways. Below is the breakdown.

Sole Trader Income Tax

The income tax of a sole trader is calculated on a progressive scale. This means that the more you earn, the higher your tax rate. The table below will detail the four different bands and the taxable income amounts.

Table

Limited Company Income Tax

A limited company’s income tax is much different:

• Corporation tax – Limited companies must pay a flat rate of corporation tax on their profits. That rate is currently 19% for companies paying £50,000 or less. This means for every £100 a company would earn, they’d have to pay £19 in corporation tax. When making profits above £50,000, the rate increases to 25%. But no higher. This can be very advantageous, as a sole trader would have to pay much higher tax rates when earning high amounts. A limited company opens itself up to the public and becomes tied to the country in a way that generates revenue not only for itself but the country it’s in. This is why the tax rate is set how it is – it’s an incentive to invest yourself in the country.
• Income tax on salaries – Directors pay themselves a salary subject to income tax, based on the same progressive rates as sole traders.
• Dividend tax rates – After paying the corporation tax and employee salaries, if the company still has profits remaining, then those profits can be distributed to shareholders as dividends. Dividends below £2000 can be received each year without paying tax, but any other that is subject to different tax rates.
  • Basic Rate (0%): If your income falls within the basic tax band (up to £50,270 for the 2023/24 tax year).
  • Higher Rate (32.5%): If your total income falls within the higher tax band (£50,271 – £125,140 for 2023/24).
  • Additional Rate (38.1%): If your total income exceeds the additional tax band (over £125,140 for 2023/24).

National Insurance Contributions (NICS) – Sole Trader vs Limited Company

National insurance is a tax paid by both employed and self-employed individuals within the UK. These contributions fund the state pension, as well as state benefits made to help low-income or otherwise struggling people who require support and are paid on top of the income tax and corporate tax that a person may otherwise pay.

Sole Trader NICs

There are four classes of NICs, and a sole trader pays one of two:

• Class 2 NICs – A class 2 NIC mandates a fixed weekly amount be paid if your profits exceed the threshold for the tax year, which is £6,725 for 2023/2024.
• Class 4 NICs – This percentage of your profits taken is calculated, after deducting allowed expenses, at 9% when earning between £12,570 and £50,270, or 2% when you go over those figures.

Limited company NICs

Limited companies have different NIC structures, and both employers and employees within a limited company are required to pay NICs:

• Employer’s NICs – A company pays a percentage of their salary as directo if it is above the tax year’s threshold, which as of 2023/2024, is 13.8% on earnings above £9,100 annually.
• Employee’s NICs – Directors also pay NICs on salaries based on the same progressive rates as income tax.

What to consider when measuring the tax benefits of each business structure?

Whilst many may hear of corporation tax and think that it’s the right choice simply due to the massive decrease of 40% in total tax, there’s more to consider than that paperwork alone. Take the following, for example.

Income Level

• Low to Moderate Earners – If income is low, then the tax advantages of a limited company may not outweigh the added complexities and costs that the business structure would bring.
• High earners – For high-earning companies, the tax savings of a limited company becomes very substantial. You will have the ability to split income between salary and dividends, significantly reducing your tax bill.

When considering whether to go sole trader or limited company, remember that there’s always the option to begin as the former and then convert later by signing up to Companies House. This is usually the best way, as low-earning businesses having to contend with administrative complexities and reporting can hamper growth.

Business Expenses

• High expenses – A sole trader that has substantial allowable expenses may find that operating as a limited company is more efficient in the long run, as these expenses can be deducted from company profits before the corporation tax is calculated. This will reduce can reduce your tax liability.
• Low expenses – If your expenses are minimal, then you can’t take advantage of taxes through corp tax.

Future Plans

• Growth – Businesses with ambition may see a limited company as a better choice, but whether or not you start as one C entirely depends on your industry, starting wealth and the level of investment you estimate you’ll receive by becoming a limited company.
• Exit strategy – If you plan to sell your business in the future, converting it to a limited company beforehand can be a massive advantage, due to the potential tax reliefs involved.

Risk Tolerance

• Anti-risk – If you’re concerned about your assets being under attack as a result of business going badly, then one of the biggest limited company pros is the legal protection it provides.
• Risk-tolerant – If you’re fine with the risks associated with unlimited liability, then keeping your own business as a sole trader may be acceptable.

Tax benefits – when to switch from a sole trader to a limited company?

As your business evolves and grows, and more income begins to generate, the income tax may end up becoming a bit claustrophobic. If you have an interest in reducing your tax burden, the only way to do so to any significant degree is by changing from a sole trader to a limited company. But when is that time? The following will go over the milestones a business can hit that signal the best time to change.

There’s no one-size-fits-all answer to when the best time to make the switch is, but many experts suggest that the time to begin seriously considering it is around £30,000 to £40,000 per year. The following breakdown example should illustrate why:

• Sole Trader – At £40,000, you will pay income tax at a high rate of 40%, most likely, on a portion of your profits.
• Limited Companies – If you were paid a salary of £25,000, and devote £15,000 to dividends, you will pay less income tax on the £25,000 whilst benefitting from lower dividend tax rates.

Once you get to £50,000, you will be in the maximum tax bracket, and you will benefit the most from transferring to a limited company.

Conclusion

For many businesses, when you’re on a roll and are making a lot of money, you will find that many of your old problems go away to be replaced with new problems.

FAQ: What is corporation tax and how is it calculated?

This is a tax on limited companies and some other organisations in the UK, calculated on the company’s taxable income. It’s calculated thus:

• Calculate Profit – Start with the company’s total income from all sources, such as investments, sales etc.
• Deduct allowable expenses – Subtract allowable business expenses, such as salaries, rent, utilities etc.
• Calculate taxable income – Whatever amount is remaining after the deductions are considered taxable income.
• Apply corporation tax – Multiple the taxable income by the current corporation tax rate.
  • The 2023/2024 financial year has set the rate as 19% for profits up to £50,000.
  • The rate increases to 25% for profits that are over £250,000
  • Profits between these two figures are at a tapered rate called marginal relief.

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